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Diamonds In The Dust

What To Buy: Masters Of Capital Allocation

The key questions the author will address in this chapter include: 

  • How to review the capital allocation decisions of companies?
  • What risks to look out for when analyzing capital allocation decisions?

What is Free Cash Flow? 

As the author has discussed earlier, a business creates value only when it earns more on the total fixed and working capital invested in the business than what it has to pay the providers of this capital. He also discussed that the difference between the RoCE and the CoC is the free cash flow of the business. But how is the RoCE linked to free cash? A simple way to understand the link between RoCE and free cash flow is to break down the calculations of these metrics into their key components. RoCE is expressed as:



Earnings before interest and tax (EBIT) measure the operating profit or return that the business has earned or generated. In this instance, the author considers EBIT and not EBITDA (earnings before interest, depreciation, amortization and tax), which is a better measure of cash flows. This is because the amount charged to depreciation can be used as a proxy for maintenance capital expenditure—that is, the minimum amount of CAPEX the business needs to undertake to maintain the current scale of operations. EBIT is the cash profit earned without any growth CAPEX (i.e., from capacity additions). From this cash profit, the business must be able to pay the providers of capital—i.e., the lenders (debt holders) and equity shareholders. And only if the EBIT is higher than the amounts due to the providers of capital will the business generate a surplus or free cash. And only if the company generates surplus cash will it have the ability to invest in capacity expansion and grow revenues and earnings further.



A key responsibility of a company’s management is deciding on the best use of the free cash flow the business generates. If a company sees sufficient growth opportunities in its business, it will prioritize the allocation of free cash for reinvesting in the business. Such reinvestment is done both to expand capacity (which drives future growth) and to deepen competitive advantages (which helps sustain RoCE higher than CoC). 


Another way of thinking about the situation is that if a company is consistently reinvesting cash flows at a rate of return higher than the cost of capital, it reflects both its competitive advantages and the management’s ability to redeploy surplus capital successfully. Therefore, the objective of the company’s management must be to keep the cycle going, building solid competitive advantages to earn high Roces, which leads to sizeable free cash generation, which in turn is invested in increasing the capital employed and deepening competitive advantages.



It follows growth that generates a RoCE less than the CoC, which is not a sensible use of free cash. Therefore, the role of the company’s management in identifying suitable investments and allocating capital toward those projects is critical. However, most businesses, even the ones with deep moats, will be eventually constrained by the size of the market they operate in. Beyond a point, the quantum of free cash flow available for redeployment will exceed the amount the business needs to keep growing. Therefore, in the absence of investment opportunities that cover the cost of capital, it is prudent for the management to return the free cash to shareholders as dividends or through buybacks. 


However, intelligent management teams and Consistent Compounders do not allow themselves to be constrained by the lack of prevailing market opportunities; they expand the business to find growth in newer avenues without diluting returns or increasing the business risk. For investors, identifying such management teams is crucial for long-term wealth creation, making Capital Allocation the third pillar of Marcellus’s investment framework.


Inorganic Product or Market Expansions are risky

Product or market extensions can be done either organically or inorganically. Organic expansions are undertaken internally, like expanding manufacturing capacity or increasing the number of retail stores, etc. Inorganic expansions are achieved by mergers, acquisitions, and takeovers—buying out a manufacturing capacity. In sectors with fragmented market shares, inorganic expansion becomes a relatively higher contributor to growth. Over time, players with strong competitive advantages in such fragmented industries tend to acquire the weaker players who struggle to cover their cost of capital on a sustainable basis. Intelligent management teams also use their strong free cash generation to buy out players in adjacent products, thereby gaining an immediate foothold in a new segment, which would have otherwise taken years to build organically.


However, market or product extensions are tricky when a company tries to enter an unfamiliar overseas market, and that too by acquiring a local player.


Unrelated Diversification poses the biggest risk:



It is evident from the Ansoff Matrix that the riskiest strategy is 'new products in new markets and the one that investors should be most wary about. Such diversification requires large capital commitments and demands a disproportionate share of management bandwidth. Moreover, as highlighted, the split focus could hurt even the core business, as competitors will exploit the opportunity to weaken the barriers to entry built-in that business. 


In pursuing an unrelated diversification, a company starts with what the author can call a double handicap—it lacks competitive advantages in the new product and the new market. More often than not, it is challenging to build sustainable advantages that allow the company to earn justifiable returns in the new business areas. And even if it is not complex to create a new business (in the sense that it is not rocket science to build a competitive advantage), it can take several years. Comparing conglomerates with companies focused on a single product/market and its adjacencies drives this point.


Timing Equity Capital raises sensibly 

Smart capital raising is also, in a way, smart capital allocation. Typically, fast-growing lenders need to raise capital every three years since a growth rate higher than RoE puts pressure on regulatory capital. KMB (Kotak Mahindra Bank) has also raised capital at intervals of three to four years, but what has set this bank apart is its ability to raise money from the capital markets while restricting the extent of equity dilution. KMB has raised equity capital through the qualified institutional placement (QIP) route twice—in 2007 and 2017—and on both occasions, at or near the market peak, which meant lower equity dilution and the resultant impact on RoE. KMB's remarkably effective capital allocation has created enormous wealth for its shareholders. Re one invested in the company on 31 December, 2000 would have become Rs 532.2 by 31 December 2020 (excluding dividends), a CAGR of 36.9%. In contrast, Re one invested in the Sensex on the same day would have grown to only Rs 12.0 by 31 December 2020, implying that KMB has outperformed the Sensex by nearly 43x over the intervening twenty years.


The Dark Side of Capital Allocation 

So far, the authors have discussed capital allocation decisions taken by the management of companies. However, in some cases, it is also very important to assess capital allocation decisions made by the promoters of companies— that is, the way they decide to deploy funds between the different businesses they own. When promoters control more than one business, there could be a risk of them trying to 'allocate' capital from a company that is doing well and generating cash flows to another business that needs funds. Such transfer of funds, even if done transparently, is seldom in the interests of minority shareholders. Usually, the board of directors would object to and block such support to other businesses of the promoter. But a desperate promoter could find means of bypassing the board too. Therefore, it makes sense for investors in any company to be cautious when the promoter has multiple businesses housed in different companies; more so if the promoters' shareholding varies from company to company and there is an incentive for them to favour a company where their shareholding is higher relative to others.


When evaluating capital allocation decisions, investors should consider the allocations made at the promoter and company levels.


Human Capital- The most critical allocation decision 

Human capital is the most precious capital of a Consistent Compounder since it helps the firm nurture a DNA of deepening competitive advantages over the long term. However, as time progresses, individuals who are part of a firm's human capital could retire, resign or get supplemented by a widening team that shares key responsibilities. Hence, a Consistent Compounder needs succession planning to help sustain its competitive advantages. However, succession planning is not an event. It is a process that must be embedded in an organization's DNA. Implementation of a succession plan is challenging at multiple levels for most organizations. For example, when a business is small, it might be run by a leader (the promoter, CEO or MD) who is omnipotent—someone who can do anything and can solve all problems. As such organizations grow bigger, the 'omnipotent' leader might feel insecure about letting go of control, which becomes particularly difficult when the firm has built strong competitive advantages under the same leader.


Moreover, if the leader builds a layer of CXOs and trains them as potential successors, then there is a risk that the trained CXOs who don't get the top job will leave the firm to assume leadership roles in other organizations. Such exits can then leave a massive void in the organization. Optimal timing for identifying a successor is also important. If the successor is identified too soon, then there is the risk of increasing attrition amongst other capable CXOs as they see themselves having hit the ceiling in their career progression. If the successor is identified too late, she might be underprepared for the role and other leadership capabilities. Promoter families run many businesses in India. 
Such promoters might think about their sons and daughters as the natural successors to head the business. However, unlike some professionals who might have worked in the organization for twenty or thirty years, successors from the next generation of the promoter family might not have spent enough time at the ground level to learn about the strengths and weaknesses of the business and may not have built trust and relationships with various stakeholders. Furthermore, there might also be more than one candidate from the next generation of the promoter family, which could create friction amongst family members.


If not appropriately addressed through a standardized and meritocratic succession planning process, such challenges can lead to strategic mistakes, deterioration in employee culture or lethargy and complacency in ground-level execution and capital allocation.


An investor's understanding of the quality of succession planning in a Consistent Compounder has to include the following four components:


1. Evidence of decentralization of power and authority—both in day-to-day business execution as well as in implementing capital allocation decisions; 
2. Quality and tenure of CXOs in the organization; 
3. Involvement and independence of the board of directors—both for decentralizing capital allocation decision making, as well as for recruitment of CXOs in the firm; and 
4. Historical evidence of the execution of succession at the CXO level without adverse impact on the organization. 


Asian Paints is one the best examples of a company that covers all aspects of its succession planning framework reasonably well. For over a decade now, the execution of operations has been controlled by empowered professionals from the CEO level down to the middle management level in the firm's hierarchy. Over the last fifty years, the firm has been hiring talent from the best universities as management trainees and has had an outstanding track record of training and retaining this talent pool for more than twenty to twenty-five years. As a result, most of its CXOs and key management personnel have spent more than twenty years at Asian Paints across several functions. Tech investments and data analytics, which also drive decentralization of execution of operations, are a large part of Asian Paints' competitive advantage. All seven independent directors on the board of Asian Paints have highly reputed and relevant professional backgrounds. And last but not least, the firm's historical track record has been healthy and consistent despite: 


a) three instances of professional CEO changes over the last fifteen years,

b) three generations of Asian Paints' promoter families having come and gone in the last seventy years,

c) one of the founding promoter families having exited in 1997, and 

d) several CXOs have changed hands regularly.


Key Takeaways of the Chapter: 

Prudent use of free cash flows is a key driver of shareholder value, and hence investors need to assess risks in capital allocation decisions.

Growth outside core products and markets must be evaluated in the context of the quantum of capital being allocated. Incremental steps towards the market and product development are less likely to destroy shareholder value than large capital commitments towards diversification. Promoters with multiple business interests call for special attention when evaluating the capital allocation decisions of any entity within a group.


A robust succession planning process and framework is the key to extracting the best returns from the most critical source of capital— human resources.

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